Continued from Part 1, here are several more terms and my definitions for them.
Financial Freedom: For Americans, at a bare minimum this should mean one can “come up with $2,000 in 30 days,” a question that Peter Tufano found only half of Americans can answer yes to. A baseline of six months’ living expenses (an “emergency fund”) is more appropriate. This gives you the freedom of not living paycheck to paycheck or being compelled to work at a bad job.
Financial Independence: I look at financial independence as a term of art meaning you have enough savings/investments to live off of in perpetuity with no earned income and no sustained drawdown of real principal. Typically, financial planners and writers say you should have about 25 times your annual expenses to do this, which is $1 million if you spend $40,000 per year. This is pretty much the same as a financial endowment at the institutional/organizational level, but instead at the personal level.
There are 329 million people in the United States (November 2018) and U.S. households and nonprofit organizations hold an aggregate net worth of $107 trillion (2018 Q2), which is about $325,000 per person if evenly distributed, or about $425,000 if only distributed among adults—enough for $17,000 per year if income at a 4% withdrawal rate.
FIRE: FIRE stands for financial independence, retire early, a grammatically convoluted acronym that indicates achieving financial independence and then exercising the option to cease having earned income (“retirement”). Of course, one can be financially independent while continuing to work, and many who “FIRE” themselves end up continuing to work on a part-time basis.
Earned Income and Unearned Income: I would just use the Internal Revenue Service (IRS) definition for these. Earned income comes from work or pre-retirement long-term disability benefits, while unearned income includes bank account interest, dividends, and capital gains (e.g., from stocks).
Securities, Stocks, and Bonds: A security is an umbrella term that encompasses equities and debts, also known as stocks and bonds. Buying “stocks” actually means buying shares of a corporation’s stock, which confers ownership and possibly shareholder voting rights. If investing in an index-tracking mutual fund or exchange-traded fund (ETF), voting rights are conferred to your custodian rather than to you (e.g., Vanguard, Fidelity, BlackRock, etc.). Corporate bonds, another type of security, represent an obligation by a corporation to repay with interest, but confer no ownership rights. Stocks are generally more profitable than bonds, but if a corporation files for bankruptcy protection, bondholders get paid first. Many argue that U.S. Treasury bonds are the best type of debt to buy, because they are backed by the full faith and credit of the U.S. government, and that the reduction in risk compared to corporate and municipal bonds outweighs the lower yield. Municipal bonds may be useful to those with higher income who are subjected to state and/or local income taxes, due to their tax-advantaged status.
Emergency Fund: An emergency fund is money that is liquid, accessible, and protected from loss of principal. This is money that you have set aside for emergencies. Because the emergency fund could be needed at any time, it usually should not be invested in stocks because stocks can experience substantial short-term declines. See “The How and Why of Emergency Funds” for more information. If you have credit cards available, most emergencies can be paid for by credit card and then repaid by the statement payment due date, without interest, as long as you have been paying the full statement balance in full each and every month (otherwise, interest begins accruing from the date of the charge). Therefore, you can use an online bank for your emergency fund with limited or no ATM/cash access and pay back the credit card using the bank account.
Inflation and Nominal and Real Value of U.S. Dollars: “Nominal” just means numbers, so when we talk about nominal returns, this means we are not adjusting for inflation. Although the Austrian school of economic thought defines inflation as an expansion of money available (e.g., the monetary supply and quantitative easing programs of the Federal Reserve), this definition is unusual and not in common use. The predominant definition/measure of inflation is based on market prices of consumer goods, represented by the U.S. Bureau of Labor Statistics’s Consumer Price Index (CPI). Nowadays, the Federal Reserve aims to achieve 2.0% inflation per year, which means prices of consumer goods should increase by 2% each year. As of November 2018, many online savings accounts are paying an annual percentage yield (APY) of 2.0%. If inflation is 2%, this means that although the nominal account balance will increase 2% in a year, the real value will remain flat. When talking about past money, it is common to use CPI data to talk about the equivalent in today’s dollars. When talking about future money, discounting returns by about 2% per year to come up with a real, present day value of future money is common. If the stock market returns 10% in nominal returns in a particular year, this is probably about 8% in real returns, due to inflation.
Here are some items I intend to define in future posts:
Market Timing, Retirement, Sequence Risk, Single-Stock Risk, Index Fund, Tax-Gain Harvesting, Mutual Fund, Exchange-Traded Fund, Diversification, Tax Brackets, Payroll Taxes, Income Taxes, Tax Avoidance, Investment Management Fees, Load Fees, Dividends, Capital Gains